Introduction
Investment decisions and long-term planning for any investment or economic action often require a complete analysis of all associated risk factors. The concept of interest rates plays an essential role in determining the cost of capital. Real risk-free and nominal interest rates have fundamental differences that determine their different investment properties. To assign value or cost to an asset, one must use the real risk-free rate because there are important reasons for this.
Risk-Free Rate
The differentiation between the risk-free rate and the nominal risk-free rate of interest can be made, indicating an important distinction. The real risk-free rate considers all side effects, such as inflation, to show a more objective situation. The nominal risk-free rate may not always be suitable for calculating the value of assets since this indicator does not consider related economic factors such as inflation (Brigham & Houston, 2021). These can significantly impact the cost, making them essential to consider.
Nominal Risk-Free Rate
The nominal risk-free rate may produce incorrect assessment data that will not be justified. The real risk-free rate has the advantage of taking into account inflation, which gives the buyer more realistic forecasts regarding the cost of an asset (Brigham & Houston, 2021). For example, one can consider a project with a rate of 2%, considered the nominal risk-free rate. However, the inflation rate is 3%, which means that using the nominal risk-free rate will be erroneous since, without considering inflation, the calculated result will be better than the actual one.
Conclusion
In conclusion, the real risk-free rate is the optimal choice for estimating the value or cost of an asset since this method allows one to consider side factors. These could include inflation, for example, which can significantly distort the final amount after recalculating financial resources. At the same time, the nominal risk-free rate cannot display the data accurately and provides only approximate information about the value of assets.
Reference
Brigham, E. F. & Houston, J. F. (2021) Fundamentals of financial management: Concise edition (11th ed.). Cengage.